Don't Go Chasing Waterfalls: Fiduciary Duties in Venture Capital Backed Startups

Abstract

We develop a model of venture capital contracting and use it to evaluate an emergent set of judicial precedents in corporate law, which we label the Trados doctrine. In our model, founders hold common stock while venture capital investors hold convertible preferred stock. We show that preferred shareholders have inefficient incentives to liquidate low-valued firms and to continue high-valued firms, while common shareholders inefficiently favor the opposite. The extent of incentive misalignment depends on the firm's intrinsic and outside valuations, and it is most severe around preferred's liquidation preference and conversion point. Although legal liability rules can rectify these misalignments, they can only do so categorically when management prioritizes {preferred} shareholders' interests. The Trados doctrine, however, generally obligates management to prioritize common shareholder's interests. Our model offers a precise mechanism for how capital structure, corporate governance, and legal doctrine jointly determine firm value.

Keywords: Venture Capital, Preferred Stock, Fiduciary Duties, Liquidation Preference, Conversion Rights, Contract Design, Corporate Governance, Efficient Breach

JEL Classification: G30, G34